Rental property investment involves the purchase, ownership, management, rental and/or sale of real estate rental property (or investment property) for profit. In addition, improvement of rental property (i.e., rental property development) is often included as part of an overall investment strategy. In general, real estate is an asset form with limited liquidity and considered to be capital intensive and highly cash flow dependent. For example, the investment capital may be raised through investor equity or mortgage leverage while the cash flow includes rental income and management expense. If these factors are not well understood and managed by the investor, real estate property can become a risky investment. The primary cause of real estate investment failure is that the investor enters into unsustainable negative cash flow resulting in insolvency or property sale at a loss.
Generally speaking, individual properties are unique and not directly interchangeable, which presents a challenge to an investor seeking to evaluate prices and investment opportunities. For this reason, identifying properties for investment can involve substantial work, which increases transactional risk but also provides opportunities for obtaining properties at bargain prices. Real estate investors typically use a variety of appraisal techniques to determine the value of properties prior to purchase. Typical sources of investment properties available for purchase includes market listings (e.g., a multiple listing service), public auction (e.g., foreclosure sales, estate sales, etc.), private sales, etc. Once an investment property is identified and preliminary due diligence (e.g., investigation and verification of the condition and status of the property) completed, the investor typically negotiates a purchase price and sale terms with the seller before executing a contract for sale.
A substantial portion of the purchase price is typically financed using, for example a mortgage loan (or debt) collateralized by the property itself. The portion of the purchase price financed by debt is referred to as leverage. The amount financed by the investor's own capital, through cash or other asset transfers, is referred to as equity. The ratio of leverage to equity (or loan to value (LTV)) is one numerical measure of the risk in financing an investment property purchase. Investors usually seek to decrease their equity requirements and increase their leverage to maximize return on investment (ROI). Lenders and other financial institutions usually require minimum equity or maximum LTV (e.g., 80 percent) for financing real estate investments. Investors seeking low equity investment strategy may explore additional financing arrangements such as seller financing, seller subordination, private equity sources, etc. Investors with large enough capital reserves may explore investment strategies to allow 100 percent equity in investment properties, which minimizes the leverage risk but also limits potential ROI.
Net operating income (NOI) is the sum of all positive cash flows from rents and other sources of ordinary income generated by an investment property (i.e., asset) minus the sum of ongoing expenses, such as maintenance, utilities, fees, taxes, debt service payments (i.e., carry cost of the investment), etc. The ratio of NOI to the asset purchase price, expressed as a percentage, is called the capitalization rate, and is a common measure of the performance of an investment property. Other conventional measure of investment performance includes return on investment, return on asset, return on equity, return on capital, etc.
Tax shelter offsets occur in several different ways, such as depreciation (which may sometimes be accelerated), tax credits, and carryover losses (which reduce tax liability charged against income from other sources). Some tax shelter benefits depends on tax profile (e.g., tax bracket, active/passive property management status, etc.) of the investor according to the laws governing tax liability in the jurisdiction where the property is located.
Equity build-up in an investment property may be a result of principal reduction portion of debt service payments or increase in market value of the asset over time (i.e., capital appreciation). Capital appreciation can be unpredictable unless planned as part of a development and improvement strategy.